collateralized debt obligations kellogg securitization colloquium may 5, 2003
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Collateralized Debt Obligations
Introduction
Market history
Market overview
CDOs are “process” not “asset class”
CDOs are an application of securitization technology under rating agency methodology to underlying assets to result in rated securities
Collateralized Debt Obligations
CDOs include:
Collateralized Bond Obligations (CBOs);
Collateralized Loan Obligations (CLOs);
Collateralized Fund Obligations (CFOs); and
Synthetic Collateralized Debt Obligations (SCDOs or CSOs).
Collateralized Debt Obligations
CDOs include:
Bonds
Loans
Emerging Market Debt
Trust Preferred
Project Finance
Distressed Debt
Middle-Market Loans
Private Equity Hedge Funds
Convertible Bonds
CDOs may soon include: Municipal Bonds
Collateralized Debt Obligations
CDOs began in 1988 with Continental Bank’s
FRENDS deal, followed by NatWest’s ROSE deals
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
However, minimal CDO activity until 1993, when
market started to take off
2002 CDO estimated issuance was $210Billion
CDO estimated current “opportunity”
is $350Billion
Collateralized Debt Obligations
CDOs are “balance sheet” or “arbitrage”
Balance sheet CDOs are a funding alternative and may have regulatory capital benefits, but are “linked” to sponsor
Arbitrage CDOs are motivated by true arbitrage
Collateralized Debt Obligations
CDOs are “cash flow” or “market value”
Cash flow CDOs use an overcollateralization (OC) ratio that measures the par amount of collateral adjusted for defaulted items
Market value CDOs use an OC ratio that measures the market value of collateral adjusted for defaulted items
Collateralized Debt Obligations
CDOs are “cash” or “synthetic” or a combination thereof
A cash CDO sells debt and equity securities and uses the proceeds thereof to acquire collateral
A synthetic CDO acquires credit exposure through credit derivatives
Collateralized Debt Obligations
CDOs use a “waterfall” to allocate “interest proceeds” and “principal proceeds”
CDOs use “eligibility criteria” and “portfolio profile” to regulate eligible collateral
CDOs use collateral tests (an OC ratio and an interest coverage ratio) to regulate collateral quality
Collateralized Debt Obligations
Underlying collateral affects the CDO
Ramp up
Collateral eligibility and profile criteria
Trading and reinvestment
Collateralized Debt Obligations
Global CDO issuance rose 38% YoY
Collateralized Debt Obligations grew 74% YoY ($208BN)
Banc Of America Securities’ 2002 CDO Data
Collateralized Debt Obligations
Cash CDOs ($60.6BN):
Banc Of America Securities’ 2002 CDO Data
35%
31%
12%
9%
8%5%
MS CDOs
HY CLOs
Other
BS CDOs
IG CDOs
HY CDOs
Collateralized Debt Obligations
Collateralized Debt Obligations (SCDOs):
Banc Of America Securities’ 2002 CDO Data
51%
38%
11%
Static Arbitrage
Balace Sheet
Managed Arbitrage
Collateralized Debt Obligations
CDOs dramatically affect markets for underlying collateral
In 2002, CLOs represented 50% of the leveraged loan market
ABS CDOs greatly facilitate the related ABS by providing the required illiquid mezzanine capital
Previously CBOs represented over 25% of the high-yield bond market
Collateralized Debt Obligations
Synthetic Collateralized Debt Obligations (SCDOs) utilize credit derivatives
Total credit derivatives are over $2TN and projected to grow to $4TN by 2005
There are active and liquid markets for CDS on prime companies in the US and Europe
But note the so-called 200/200 tiering
Collateralized Debt Obligations
Credit derivatives are an extremely sophisticated and powerful financial product
However, their flexibility and novelty often makes their characterization more difficult
Specifically, issues regarding whether the credit derivative is insurance for tax purposes or does it require insurance company status/regulation
Collateralized Debt Obligations
Synthetic CDOs use credit derivatives to acquire credit exposure w/o transfer or, in some cases, funding of asset
CDOs, including SCDOs, are an application of securitization technology under rating agency methodology to underlying assets to result in rated securities
Collateralized Debt Obligations
Credit derivatives are
Total Return Swaps or TRS
Credit Default Swaps or CDS
Credit-Linked Notes or CLNs
Basic Total Return Swap
Total Return
Bank pays Customer the total return on the referenced
assets. Bank has reduced credit risk to reference assets,
but acquires credit risk of Customer.
Basic Total Return Swap
Financing Charge
Customer pays Bank a specified financing charge and
acquires credit risk of reference asset.
Basic Credit Default Swap
Bank/Customer “buys” credit protection on a referenced
entity and pays a credit spread therefor.
Credit Protection
Basic Credit-Linked Note
Credit Linked Note
Bank issues a credit linked note that pays (or, if a credit
event occurs, doesn’t pay) the principal of, and interest on, a
reference asset. Bank has reduced exposure to credit risk
of referenced asset.
Basic Credit-Linked Note
Credit Linked Note
Customer purchases the note and acquires credit risk of
reference asset.
Collateralized Debt Obligations
ISDA’s 1999 Credit Derivative Definitions and elective Supplements regarding
Convertible, Exchangeable and Accreting Obligations
Successor and Credit Events
Restructuring
Draft 2002 Credit Derivative Definitions Adoption expected 05/03
Collateralized Debt Obligations
Advantages
Avoid transfer issues (consents, etc.)
Quicker execution?
Simpler documentation?
Collateralized Debt Obligations
Disadvantages
More complex accounting (FAS133 and DIG/ED D2 model) and tax (NPC or financing)
Precision?
Legal?
Collateralized Debt Obligations
3 Types of SCDOs
Balance Sheet SCDOs
Tranched Basket/Portfolio SCDOs
Managed Arbitrage SCDOs
Collateralized Debt Obligations
Bank CDO
ClassA
ClassB
ClassC
CDS
Notes/Swaps
Bank obtains economic and regulatory capital relief. Investors obtain credit exposure and return
Balance Sheet SCDOs
Collateralized Debt Obligations
Issuer CDO
ClassA
ClassB
ClassC
CDS
Notes/Swaps
Issuer reduces credit exposure
Investors obtain credit exposure and arbitrage return
Tranched Basket/Portfolio SCDOs
Collateralized Debt Obligations
Bank CDO
Manager
ClassA
ClassB
ClassC
CDS
Notes/Swaps
Manager selects and manages portfolio to enhance arbitrage opportunity
Managed Arbitrage SCDOs
Collateralized Debt Obligations
Feature Static Managed
Trading CDS Long Only
No removal or substitution
CDS Long/Short
Exposures added and/or removed
Excess Spread Fixed CDS premium
Credit-related premium
Excess spread released, trapped or used to offset losses
CDS premium reflects credit and management
Comparison of Static and Managed SCDOs
Collateralized Debt Obligations
Feature Static Managed
Liquidity Credit Events Credit Events
Trading losses
Counterparty Risk
Single CDS counterparty
Exposure to protection buyers only
One or more CDS counterparties
Exposure to protection buyers and/or sellers
Comparison of Static and Managed SCDOs
Collateralized Debt Obligations
Feature Static Managed
Portfolio Initial guidelines only
Minimum WARF, WARR and/or WAS
Limits on total CDS short and offset exposure, trading and concentrations
Structure Credit enhancement only
OC and IC tests
Limits on counterparties and required CDS documentation
Ramp-up restrictions and minimum notional balance
Excess spread trigger/trap
Comparison of Static and Managed SCDOs
Collateralized Debt Obligations
Trading Criteria
Minimum CDS reference entity ratings
Minimum CDS premiums
Required CDS documentation
Maximium total CDS notional balance
Maximum loss threshold (after which ‘switchback’ to static)
Identical CDS terms for offset
Mitigated market and counterparty risk
Required CDS removal for rating downgrade/negative watchlist
Permitted substitution if portfolio improvement/maintenance
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